Shell & Big Oil's Exploration Challenge

The oil business used to be simple. Find oil. Drill hole. Sell oil. Buy Stetson and private jet.

These days, you have to corral an army of engineers in the desert to build an enormous factory to transform natural gas into a liquid to be used like oil. The capital cost of Royal Dutch Shell's Pearl gas-to-liquids plant in Qatar is a cool $18 billion or more -- 10% of its market capitalization. Like Chevron's Gorgon liquefied natural gas project offshore Australia, it shows what big integrated oil companies are capable of.

But have they neglected bread-and-butter exploration for lower risk, lower return engineering projects? Certainly, investors are unimpressed. A decade ago, the international oil companies (IOCs) accounted for 79% of energy sector market capitalization and nearly all its net income. Today the figures are 53% and 62%, according to Sanford C. Bernstein. Shell trades at a discount of 13% and 36% respectively to the 2010 forward price earnings multiples at Petroleo Brasileiro and BG Group. But their estimated five-year average output growth is 5% and 9% compared with Shell's 3%, around the IOC average.

If there is a premium on growth, why have the IOCs not spent more on exploration? The question is a little unfair. The majors are so big they spend billions simply replacing the barrels they produce. Geopolitics and resource nationalism have narrowed growth options.

It takes a big discovery to move the needle. Shell more than doubled its exploration budget to $1.4 billion between 2004 and 2008 when it represented 3% of net cash from operations. But contrast that with the 16% of net cash from operations spent by the smaller BG which has made exciting finds offshore Brazil, alongside Petrobras, and West Africa. That's why Bernstein analyst Neil McMahon questions whether IOC executives have sufficiently examined the merits of exploration over one-off engineering marvels. Facilities like Pearl have to be built on giant, long-life gas fields which are rare.

Intriguingly, Shell, scaling back development of its Canadian high-cost tar sands operation, has bumped up its exploration budget to $3 billion, around 10% of capex. But could it spend even more? With their huge upfront cost sunk in 2011, Shell's two Qatar projects will generate $4 billion a year in cash flow. They will be nicely geared to any rise in oil prices at a modest unit cost of $6 per barrel of oil equivalent. Few IOCs may be as well placed as Shell to take on more exploration risk.